Edmond Jackson's Stockwatch: ASOS is meat for long and short traders

Is a high price/earnings (P/E) multiple destined to "revert to the mean"? A dilemma with the most successful and promising businesses is stockmarket expectations running very high - so when challenges creep in there is an inevitable de-rating.

No business grows even at 20% a year forever (does anyone recall the pitfall of Rentokil's chairman, "Mr 20%"?) so beware forward P/E's in the thirties and higher. Certainly very few businesses can sustain a high P/E for a long while; even the rating for microchip behemoth ARM Holdings is declining.

If capital protection is your first goal then avoid tucking away highly-rated growth shares; but if you are alert and nimble this area offers fabulous long/short trading. The key is being attuned to change in the story.

A snakes and ladders game

After a very strong run to 7,050p by early 2014, the chart for the AIM-listed shares in online fashion retailer ASOS plunged to 1,785p - currently about 2,200p - as various factors conflated for profit warnings. Even after a 70%+ drop the stock trades near 50 times forecast earnings albeit possibly under 1.5 times revenues. Mind any relationship between the two simply reflects industry margins, i.e. a less-demanding price/sales ratio is to be expected here.

Still, according a high P/E though, the market assumes ASOS can raise overall margins once it is established as a truly global business. The chief executive Nick Robertson has made plain, "We are in a period of major investment that comes at a short-term cost but the medium-term benefits will be significant."

The stockmarket dynamics here may also reflect a bandwagon effect where ASOS was seen as one of the prettiest faces in a Keynesian beauty contest, as excitement rose in the 2012/13 "QE3" period of loose monetary policy. My Stockwatch pieces include many examples of stocks consolidating in 2014; but ASOS had become so highly valued it was subject to a reversal and new self-reinforcing trend on the downside as various setbacks attracted short sellers and shareholders’ stop-losses kicked in.

Top executive director opts to buy heavily

Besides a 27% revenue rise for the financial year to end-August 2014 a key development likely to arrest the downtrend in the short term is the recent finance director – now chief operating officer - splashing out half a million pounds buying shares at 2,249.6p, taking his stake to 149,944 shares or £3.373 million worth.

That's a serious buy from the person who above all should know ASOS' numbers and operations intimately; who is increasing his already high financial risk of a focused exposure to one business. It's no guarantee and may involve some animal spirits; but it must imply a longer-term rationale.

Thrust of the long-term "buy" case

It takes some speculative leap of faith, but this business could be in a very strong global position, three to five years hence. It has already achieved a loyal following among 20-somethings who become 30-something customers: the group's websites are attracting 71.2 million visits a month and at end-August had 8.1 million active users - up from 7.1 million a year before - with 3.4 million located in the UK and 5.4 million internationally.

That means sterling's recent strength partly explains annual pre-tax profit down 14% to £46.9 million as it forced discounting, especially in Australia. The range of inventory is a competitive advantage and any rival will struggle to offer and sustain the likes of £161.5 million inventories (end-August balance sheet). ASOS range has expanded to over 800 brands alongside its own, and there is a wide range of sizes.

The website itself is quite a competitive advantage akin to a fashion magazine able to attract customers without incurring expensive advertising. Delivery arrangements are attractive with free standard delivery on orders over £15 and free next-day delivery by 10pm over £100 otherwise £5.95 cost.

Altogether these factors helps establish quite a moat around the business and it is hard to imagine main UK rivals - Next/Littlewoods - encroaching; or indeed any new entrant replicating ASOS' extent of supplier relationships and stock on a profitable basis. So you are not going to see an Aldi/Lidl type incursion like in supermarkets. Indeed Zalando, founded in Germany in 2008, has in the last three years spent over £315 million equivalent establishing itself across Europe, meanwhile ASOS has enjoyed a pre-tax return on capital employed of about 30%. Entering new markets also requires little fixed investment as they can be serviced from the UK initially.

The aim to become a leading global fashion destination by 2020, with £2.5 billion sales compared with about £1 billion currently; and if that follows then undoubtedly a premium P/E multiple will apply. But roughly how high is justified?

Current rating still leaves no room for setbacks

The 2020 sales target implies ballpark EPS of 150p i.e. at least five years before the P/E multiple reduces to the low/mid teens - the rating Next shares have been established on for the last five years (and still achieved a bull run from 1,800p over 7,200p).

So, in theory ASOS is liable to trend in a volatile-sideways trend with its 2012/13 blow-off a curiosity of monetary expansion. In practice the story is going to dictate the trend. For example, there needs to be no more significant price-cuts beyond what have been needed to clear excess stock and deal with currency differentials, otherwise margins hence the rating will be affected.

This is quite a risk if signs grow internationally, of deflation and low economic growth. More positively, young people may continue to resort to fashion as a pep-up despite tough times, like the trend for personal fitness has boosted sports-gear sales.

January 2015 trading statement will set any near-term trend

Buyers are taking some leap of faith in this becoming an Amazon-style, global business with an enduringly high P/E. That's possible, but after a few warnings and a share price debacle, the market is likely to seek more proof. The stock looks likely to trade sideways until a four-month trading statement in mid-January 2015; potentially meat either way for long/short traders.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.